The credit crunch and climate change

The credit crunch reveals at least one important thing about major policy decisions: once they are taken, one way or another, it becomes impossible to fully evaluate what the world would have been like without them.

Plenty of people claim that it was terribly necessary to bail out the banks and car companies, cut interest rates, and wreck the public finances by splashing out on every sort of tax cut and government spending program. They argue that doing so made this into a minor recession compared to a decade-long global recession. Having taken those actions, our ability to know what the world without them would have been like is very limited. The unknowable costs of inaction can always be used to respond to examples of cases where action currently seems unnecessary: “Yes, it was regrettable for the investment bankers to pay themselves off with taxpayer money, but the alternative to all this would have been a terrible global depression!”

The same will eventually be true of climate change mitigation policy. Say we eventually make it a real priority – setting a high price on carbon and really focusing on de-carbonizing our infrastructure. At some point in the distant future, we will look at our efforts and at how much climate change occurred. Provided it was a non-catastrophic amount, we will be in the same situation as we are now in relation to the credit crunch. We will be unable to know how bad things would have gotten if we had not taken action,

That being said, the stakes are enormously higher with climate change than with the credit crunch. While global economic turmoil would hurt, climate change risks destroying or severely degrading the capability of the planet to sustain human life. The risks associated with allowing it to occur to an extreme extent are practically incomparable.

It should also be noted that the credit crunch bailouts served a purpose that we must look on with increasing suspicion: maintaining economic growth. While we should certainly hope that human welfare will continue to improve, it is tautologically the case that we will eventually need to move to an economy in a steady state, when it comes to the resources it extracts from the atmosphere, lithosphere, hydrosphere, and biosphere, and in terms of the wastes it ejects into those places.

“There has been a lot of collateral damage. Average unemployment across the OECD is almost 9%. In America, where the recession began much earlier, the jobless rate has doubled to 10%. In some places years of progress in poverty reduction have been undone as the poorest have been hit by the double whammy of weak economies and still-high food prices. But thanks to the resilience of big, populous economies such as China, India and Indonesia, the emerging world overall fared no worse in this downturn than in the 1991 recession. For many people on the planet, the Great Recession was not all that great.

That outcome was not inevitable. It was the result of the biggest, broadest and fastest government response in history. Teetering banks were wrapped in a multi-trillion-dollar cocoon of public cash and guarantees. Central banks slashed interest rates; the big ones dramatically expanded their balance-sheets. Governments worldwide embraced fiscal stimulus with gusto. This extraordinary activism helped to stem panic, prop up the financial system and counter the collapse in private demand. Despite claims to the contrary, the Great Recession could have been a Depression without it.”

THIS week, in advance of its “emergency budget” on June 22nd, we wrote about how Britain might close its deficit, which currently stands at 11.1% of GDP. One idea we advocated was a carbon tax. We commissioned some modeling on the subject from Cambridge Econometrics (who have a model specifically designed for this sort of thing). I wrote up the headline results in a small piece to accompany the main article, but space constraints prevented me going into too much detail. Happily, space constraints don’t apply on the web.

The Economist has long advocated a carbon tax as the best way to deal with climate change. Carbon taxes are a subspecies of Pigovian tax; taxes that are designed primarily to change behaviour rather than to raise revenue. The idea is to try to manipulate the price of a good or a service in order to capture all the negative externalities it imposes. Pollution is the standard example: neither the owner of a factory nor the buyer of its goods, for example, care very much that the local river is being filled with nasty chemicals as a byproduct of the factory’s work. Those who live by the river do care, but, not being party to the transaction, there isn’t much they can do about it. The uncompensated costs imposed on locals by the factory-owner’s activities represent a market failure. In theory the government would step in and impose a tax on the factory owner designed to compensate the locals for the damage caused by his actions (in the jargon, the government would make sure the private cost of producing the goods was equal to the social cost).

It’s the sort of dry, neat idea that appeals to professional economists, but there are reasons for advocating carbon taxes in the real world, too. Having one, unchanging price for carbon offers certainty to businesses and the public (unlike cap-and-trade schemes such as the EUETS, which has seen big price fluctuations), an important benefit to industries like power generation, which produces a lot of greenhouse gases and which must be confident that an expensive new power station will stay profitable for several years. And yes, before you rush to the comment button, there are important downsides, too. I’ll explore some of those below.

With all that in mind, we investigated two different basic scenarios. One applied an economy-wide carbon tax that aimed to raise 1% of GDP in revenue by 2020; the other applied a tax set at a level designed to ensure that Britain meets its commitment to cut emissions by 34%, relative to their 1990 levels, by 2020. In both cases, to keep things simple, we scrapped all the other policies that aim at the same outcome, such as Britain’s membership of Europe’s emissions-trading scheme, subsidies for renewable energy and so on. The results of the first scenario are set out in the print piece, but briefly, electricity prices fall as expensive subsidies for renewable energy are replaced by the carbon tax. That provides an economic boost, the government gets an extra revenue stream, and output is 2.5% higher come 2020 than in the baseline scenario. Somewhat embarassingly, emissions of carbon are slightly higher than in the baseline scenario. But we chose 1% of GDP as our target figure for convenience more than anything else. There’s no reason the tax couldn’t be tweaked a little to reduce emissions, although a high enough tax would presumably start to drag GDP back down again. At any rate, the modeling strongly suggests that a tax would be much more efficient than the present arrangements.